What Happens to AI Stocks if the Fed Hikes Rates Again?
Key Points
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The Federal Reserve raised interest rates in September, and investors expect another hike by December.
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Higher rates can weigh on growth stock valuations and make AI infrastructure more expensive to finance.
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AI companies that can fund their growth with cash should hold up relatively well.
The Federal Reserve raised rates in September for the first time since 2023, in response to stubbornly elevated inflation. But investors don’t believe the central bank is finished just yet. With the September CPI report showing 3.7% year-over-year growth in consumer prices, investors are betting on at least one more rate hike before the end of the year.
According to the CME Group’s FedWatch tool, which shows the rate moves being priced into futures markets, there’s only a 15% chance that the Fed will hike rates again at its October meeting next week. But there’s a massive 88% chance priced in that we’ll see at least one more rate hike before the end of 2026. And the base expectation, looking further ahead, is for at least three more Fed rate hikes before the end of 2027.
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AI stocks have been under pressure lately, and although it isn’t the only reason why, rising interest rates have a lot to do with it. Let’s assume for a minute that the Fed is going to raise rates once more this year. What would it mean for AI stocks?
Why do interest rates matter for AI stocks?
At first, it might seem like AI stocks should be one of the least rate-sensitive parts of the market. It’s well-known that businesses like real estate investment trusts (REITs) and other high-yield stocks can be quite vulnerable to rising rates, but why AI stocks? There are two main reasons:
First, rising interest rates reduce the present value of future earnings, and fast-growing companies (like many AI stocks) get their value from what they’ll earn in the future, not what they’re earning now. This is a big reason why the Nasdaq was the worst-performing of the three major stock market indexes in 2022, when the Fed was forced to aggressively raise rates.
Second, the AI build-out is extremely expensive. Many companies are increasingly financing it with debt. When rates rise, so do borrowing costs, and companies that are relying on debt can be forced to pump the brakes on growth.
Which AI companies could take a hit?
First, there are plenty of AI companies that should be minimally impacted by another rate hike. Specifically, companies that aren’t affected much by either reason discussed in the last section. Think Nvidia (NASDAQ:NVDA) and Alphabet (NASDAQ:GOOGL). Both generate massive amounts of cash today, so their valuations aren’t as dependent on future earnings, plus they can fund their AI infrastructure needs with minimal borrowing. While a rate hike could certainly be a headwind for near-term stock performance, it isn’t a threat to the business performance.
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On the other hand, companies that aren’t yet highly profitable, or that depend on capital markets to fund their AI build-outs, are far more vulnerable. Think of CoreWeave (NASDAQ:CRWV), which is borrowing heavily to build its data centers. Investors are already nervous about the ability of several companies to pay for their ambitious growth plans, and a rate hike certainly won’t help cool those fears.
The bottom line
One additional rate hike isn’t likely to be a crushing blow, even for stocks in the latter group. The 10-year Treasury yield is already above 5%, so it’s fair to say that the market has largely adjusted to a higher-rate world.
What’s really worth watching is whether credit markets continue to tighten for AI-related borrowing. Regardless of how high benchmark interest rates go, as the perception of risky debt increases, AI debt could become far more costly. For this reason, I tend to favor AI companies that fund themselves (or at least have the ability to), and I’m far more selective with those that need to borrow.
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Matt Frankel, CFP® has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet and Nvidia. The Motley Fool has a disclosure policy.